Liquidity risk and sovereign risk premia

A working paper from the Bank of Canada uses arbitrage-pricing theory to study the relationship between liquidity risk and sovereign bond risk premia in the London Stock Exchange in the late 19th century.

The research reports three key results:

· sovereign bonds with wide bid-ask spreads earn 3-4% more per year than bonds with narrow bid-ask spreads;

· small sovereign bonds, as measured by market value, earn 1.8-3.5% more per year than large sovereign bonds; and

· market liquidity is a state

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